I’m back with the second issue in a 4-part series on college savings. Last week, I talked about how to prioritize retirement vs. college savings. This week we'll talk about where to put your hard-earned college funds as you prepare the way to higher ed for your children. So let's jump to the big questions on this topic.

Should I use my retirement savings account to save for college?

A lot of people choose to put their children’s college savings in their retirement accounts (e.g., 401k or IRA). Those tax-advantaged accounts are a great tool, so this seems reasonable, right? However, they are actually not the best vehicles for funding a college education. Here’s why:

Taxes & Penalties: The money in your retirement accounts cannot be withdrawn until you’re 59 ½. Early withdrawals are subject to income tax AND hit with a hefty penalty from the IRS. The money can be borrowed, but if you leave your job while the loan is outstanding for any reason, the money has to be repaid in 60 days or it will be treated as a withdrawal.” I don’t recommend taking a loan from your retirement account to pay for college.

Financial Aid: Saving in a retirement account also doesn’t maximize what you can get from federal financial aid (more on that in a moment). Remember, I made this handy overview of maximizing financial aid for you.

Two Different Goals: Additionally, as I mentioned in the last article, you should prioritize your retirement savings ahead of any college savings. I believe you’ll have more success with this if the money is kept separate. Combining money for two very different goals is hard to manage and I’m all about ease and clarity when it comes to money.

Should I use my savings account to save for college?

Again, the short answer is no, but it does depend on the age of your child.

At best, your cash sitting in a high-interest savings account is earning less than 1% a year. Compare that to regular inflation of around 3% a year (i.e., the natural increase in the price of basic goods like milk or rent) or the rate at which college tuition is growing (about double regular inflation), and your cash just can’t compete. When you’re saving for a goal that is years down the road, you want your money to grow faster than inflation.

The caveat here is that as your child gets closer to going to college, you will want to move your college savings into less risky investments. So eventually, cash is appropriate.

In whose name should you put your college savings?

Generally, it’s better to keep college savings in the parent’s name, not the child’s. In financial aid formulas, assets count against you. In other words, the more you have, the less financial aid you get. However, assets in your child's name will be weighted against him much more so than anything in your name.

So, what do the experts suggest?

Experts say that an investment account called a 529 plan, in the parent’s name (the child is the beneficiary), is the best tax-advantaged place to put your college savings. Don’t feel bad if this is the first you’re hearing of 529 plans. You’re in good company, only about 1/3 of Americans know what a 529 plan is.

So why is this the preferred way to save for college?

Tax advantaged: As long as the money in the account is eventually used for "qualified educational expenses" (which are tuition and fees required for college enrollment, more on this in part 3), your 529 contributions will grow tax free! What does it mean to grow “tax free”? Imagine that you contribute $1,000 and it grows 6% to $1,060. Because growth is tax free in a 529, you won’t have to pay taxes on that extra $60. You would have to pay tax on those $60 gains if you had put your $1,000 in a traditional 401k or a regular savings account instead.

State Tax Deductions: Each state has its own plan (you can research them here), and some states even make the amount you contribute tax deductible. For example, New York offers a tax deduction for 529 contributions up to $5,000 per individual or $10,000 per couple, per year.

Maximize Financial Aid: The financial aid that your child is eligible for will be reduced depending on what assets you have. I’ve already mentioned that your retirement account distributions (not the account balance, just what you withdraw from the account to pay for college), or assets in your child's name, will result in bigger dings and smaller aid packages. A 529 plan in the parent’s name will result in the smallest ding and the largest aid package.

Action Plan

This week, work on the following action steps:

Track down records of any current college savings you've already set aside, if any:

How much have you saved?

What about friends or relatives, like grandparents? Have they contributed any money for college funds? Add that to your total saved.

Where are college savings saved?

In whose names are the accounts set up?

Decide where you would like to keep college savings, going forward. Would you like to open a 529? Would you like to roll over any existing college savings into it, or leave them where they are? More on this come…

Next week (in issue #3 of 4 on this topic), I’ll talk about how much you should be saving in your kids' college funds.